WHERE ARE EARLY-STAGE INVESTMENTS GOING?

Smart money from startup investors follows ever changing trends in terms of sector, region, stage, and instrument. Startup investors, including business angels, VCs, family offices and corporate VCs can invest directly into startup investment rounds, or join co-investment funds, syndicates or invest in other funds. Funds are increasingly set up as specialised sector funds. They also differ depending on the active or passive involvement that they exercise in the startup. Blockchain technology and ICOs are also changing the landscape of startup investments, even though, similarly to crowdfunding, they are relevant only to some companies depending on the business model and characteristics.

Sectors are key to the majority of startup investment decisions. What business angels invest in may be more varied, depending on recommendations and special interests, but many funds tend to look for specific sector investments based on the latest trends. Technology and business model is becoming key to any new venture’s success. At the moment, AI and machine learning, blockchain, B2B and enterprise-related business models, as well e-commerce platforms tend to catch the investors’ attention. Early-stage startups in sectors that are not among the current top trends, may have a harder time getting through to top investors, but they have the option to concentrate on investors who specialise in their industry, as well as to adapt their business model to the current growth trends. Even more diversified investment funds tend to look for specific sectors, due to FOMO (fear of missing out), by following the lead of experienced investors and funds. Increasingly, many VCs are opening specialised funds, or are born specifically to invest in a particular sector, which helps the fund become an expert in the field, and to market the fund to their respective investors more clearly.

Blockchain companies have become a ‘must-have’ in many portfolios, as the sector could potentially have very wide applications. Many startup investors are also participating in ICOs and crypto-investments, which may have taken away some liquidity from the traditional startup fundraising market, and may have taken attention away from other technologies and business models with high-potential. It’s difficult to foresee the impact of ICOs: on one side, they bring the much needed liquidity and exit possibilities that early-stage investors need, while on the other side they do little to increase trust and transparency in startup investments. To avoid regulations, many ICOs have been in the form of utility tokens, with unclear regulations, no real traction for many, uncertainty in investor returns (as the future of the utility token market is hard to predict) and currently little utility, which resembles more reward-based crowdfunding. Occasionally some small investors also seem to believe that they are investing in a company, in ownership, in equity, which adds to the confusion. In the future, it is likely that utility tokens will take place mostly for growth stage companies that will sell a real utility to investor, and that more ICOs will be in the form of security tokens, once regulations become more certain.

Some say that ICOs have allowed for investors to put their money in teams that they have never met, on the other side of the world. But in reality, in many cases nothing stops investors from doing the same with traditional startups. Early-stage investment risk is mostly about the team and their ability to implement their business plan and sell, that’s why, at least for the lead investor in a round, it is important to know the team, possibly over several interactions, which is difficult to do with overseas investments. ICOs instead, have made risk acceptable, as investors have been attracted by the potential huge returns of these investments and the hype, but that doesn’t eliminate the team risk of seed stage startups that raised millions without having a finished product.

Artificial intelligence, blockchain and particularly e-commerce are also allowing Africa and South-East Asia startups to attract investments as these markets become increasingly digital. Most funds investing here are specialised in these regions, as even the same products present in Western countries, are subjected to very different business dynamics here, but the number of these funds in increasing, especially corporate VCs and specialised investment programmes by internet and technology giants. Most investments are still concentrated in the US, Europe, Israel and China.

Elisabeth Yin has a great explanation about the current investment trends in seed stage rounds. She explains how seed stage investments are becoming smaller in size and practically divided in tranches with multiple seed stage investments taking place before Series A, which are postponing and raising the ticket for the typical series A round. Many family offices are also actively starting to invest directly in startups, and some are specialised in seed stage rounds as well.

Finally, there are various instruments typically used to invest in a startup during the early-stages, but in the vast majority of cases preferred equity and convertible debt are the instruments of choice. Convertible debt is popular at seed stage, as it becomes less important to determine a valuation immediately, which is beneficial before Series A as there may be seed rounds that require short negotiations.

As a founder, you own common equity in your start-up. Preferred equity or convertible debt carry different ownership rights. Investments in the form of common equity and loans also take place, but less often. Revenue-based or royalty financing may be suitable only in some circumstances: here investors are entitled to a pre-defined portion of your revenue.

With VCs that are now investing in token sales and options, instruments are diversifying. Later-stage lead investors may have more restrictive term sheets, with a variety of rights attached to the investments.

for startups: PROS CONS
Common Equity Higher residual income for founders in case of exit, liquidation event Voting rights; Expensive transaction costs
Preferred Equity Less control of shareholder, depending on term sheet clauses Additional rights for conversion, profit split, exit and liquidation, Transaction costs
Convertible Loan Lower transaction costs; No valuation needed; No investor voting rights High risk of dilution; Converted into stock at a future round with a valuation cap
Loan No equity given to investor Repayment schedule; Hard to be granted one without credit history; Insolvency risk
Revenue-based Financing No equity or fixed payment schedule % of revenue paid to investor whether the company is profitable or not